Blue Chips Are Crazy Cheap

In the typical Simpsons episode, some wacky event yanks you off in one direction only to swing you in another direction entirely a few minutes later. That's exactly how I felt yesterday.

First, Fool reader truthisntstupid offered the following comment on my article, "Will This Decade Tank Your Portfolio?":

Some people are always bringing up how badly a group that included a bunch of people who were willing to buy ridiculously overvalued stocks did.

I want to know how people that demanded a dividend of >3% and a P/E more in line with (or less than) the S&P did as a group.

I couldn't agree more, so I decided to dig up those numbers.           

Survey says ...
Since investors were oh-so-willing to pay up for even unprofitable companies a decade ago, I used a revenue multiple instead of the price-to-earnings ratio and, sure enough, the numbers played out just as I (and truthisntstupid) might have imagined.

Looking at all stocks with a market cap of $100 million or more, the median return between the beginning of 2000 and today was 19.3%. The median price-to-revenue multiple for that same group was 2.42.

Now if we strip that group down to only stocks with a price-to-revenue multiple below the median and a dividend above 3%, the median return jumps to 88.5%. And if we go the other way? If we look only at stocks with multiples above the median and no dividend at all, the median return drops to a 50.2% loss.

That doesn't mean that there weren't losers in the former group and winners in the latter. Though Ford (NYSE: F) is regaining darling status today, it's had a pretty ugly decade. It had a below-median revenue multiple and a 3.5% dividend back in 2000, but its stock has still lost 53% of its value. On the flip side, Apple (Nasdaq: AAPL) didn't (and still doesn't) pay a dividend and had an above-median multiple, but its turnaround that did (and continues to) wow investors helped the stock deliver impressive returns.

But the message is clear and really nothing all that new: Look for stocks with low valuations and solid dividends, and you'll up your chances of success.

But now the story changes
When I stepped back and looked at those numbers, though, I found myself a little surprised by one number in particular. Above, I noted that the median return for all stocks with a market cap of $100 million or greater between 2000 and today was 19.3%.

But how can that be? Wasn't the past decade a lost decade for investors?

Sure, 19.3% over a decade is hardly worth crowing about -- it's less than 2% per year. But it's not the nasty loss that's so often cited for the past 10 years. So what gives?

It all depends on where you're looking. What we generally spend our time focusing on either the Dow Industrials or the S&P 500, both of which are large cap indexes. Over the past 10 years, the Dow lost 3.2%, and the S&P 500 dropped 20%. But the small-cap-focused Russell 2000? That's up 40%!

For an entire decade now, small caps have been kicking large-cap butt all over the market.

Source: Yahoo! Finance.

Are small caps simply better investments than large caps? Well, they can be. Because of their size, small caps typically have a lot more room to grow, and they're often ignored by Wall Street, giving you the opportunity to jump on them before everyone else comes running.

But the outperformance of small caps over the past decade has a much simpler explanation. Back in 2000, the median price-to-earnings ratio on stocks with a market cap of $10 billion or more was a whopping 32. For stocks below the $10 billion threshold, the median P/E was less than 16. That's right, by and large, large caps had valuations that were more than twice that of their smaller brethren. So it's no wonder small caps have outperformed ever since.

But that's not the case today. In fact, the two groups have changed places over the past 10 years. Currently, stocks with a market cap of more than $10 billion are the cheaper group, with a median P/E of 16.7 versus 17.1 for the small fries.

What does this mean?
It means that right now we can buy shares of many of the best and most admired companies in the world at prices we haven't seen in a long, long time. Even at the depths of the Internet bust in October of 2002, the big-cap club fetched a median P/E of more than 21.

But, you may wonder, if the group has fallen this far, couldn't it fall further? Sure it can. The market isn't always long rationality. That said, I think today's prices look pretty attractive, so I'm comfortable buying today and then adding to those positions if prices get even cheaper.

As far as I'm concerned, keeping it nice and simple is a winning strategy right now. Specifically, that means focusing on quality, sticking to the stocks that still have low valuations, and demanding a decent dividend. Here are a few stocks that fit those criteria.

Source: Capital IQ, a Standard & Poor's company.

I personally own shares of Intel, Abbott, and J&J, and both Exxon and Lockheed are high on my watch list -- though writing about them here now restricts me from buying shares for a while.

Have some top large-cap picks of your own? Or do you think my faith in blue chips is batty? Head down to the comments section and sound off.

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